Rating Agencies Update: Happy Days are Here Again … But Will They Last?

The hospital sector saw one of its best years in recent memory during 2015. As a result of the Affordable Care Act (ACA), expanded insurance coverage was in full swing, along with a recovering economy, robust revenue growth and low interest rates.

Readers may recall that 2014 showed improvement for the higher rating categories (“A-rated” and above), but the lower investment-grade and non-investment grade categories struggled. In 2015, the positive trend continued for the higher rated providers, but the improvement was more widely disbursed. The consensus theme of the three largest credit rating agencies (CRAs) is that all rating categories saw improvement. However, all CRAs cited economic and other factors that will challenge the industry in the near future, with smaller systems and stand-alone hospitals disproportionately affected.

Each of the CRAs issue an annual report that summarizes past performance and provides a forecast for the upcoming year. With approximately 95% of the world market share for credit ratings, Fitch Ratings (Fitch), Moody’s Investor Service (Moody’s) and Standard & Poor’s (S&P) reports provide a wealth of information which systems and stand-alone hospitals can use to make meaningful comparisons to financial benchmarks and emerging trends.

Operating Performance

One of the key observations noted by the CRAs was the improvement in operating margins for most providers, realized through a combination of good revenue growth and continued expense controls. All three agencies noted that 2015 was the first full year with any significant increase in insurance coverage attributable to the ACA, continuing a trend that began in 2014. Obviously, providers in “Medicaid expansion states” benefitted more, but there was improvement in most other states as well.

  • Moody’s reported a six-year high in annual revenue growth (7.5%), while expenses grew at a slower pace for the second consecutive year. All CRAs cited the Medicaid expansion and consolidation as the driving factors for the dramatic increase in revenue growth. While organic growth was prevalent across the board, Moody’s noted that revenue growth was greatest in the largest hospitals and systems because of consolidation. All three agencies expect that the effect of Medicaid expansion will moderate in 2016 and revenue growth will slow significantly.
  • While revenue increased, health care providers are effectively checking expense growth with increased operating efficiencies. Consolidation continues to provide benefits vis-a-vis economies of scale and operational synergies, in addition to better negotiating leverage with vendors and payors. S&P noted that many hospitals and systems are realizing the benefit of improved IT infrastructure that was put in place in recent years. Many systems have digested the expenses incurred with IT implementation and are seeing improvements in revenue cycle, inventory and supply management, and labor productivity. Fitch, however, did point out a few examples of downgrades resulting from poor implementation of IT systems.
  • As noted in the rating reports from last year, 2014 was the first year in which providers had assurance that ACA was here to stay. The resulting increase in Americans with health care coverage started to manifest in higher volumes in 2014, and the trend continued throughout 2015. The gains were largest in the Medicaid expansion states, but the CRAs noted that increased coverage is relatively widespread. However, Fitch and S&P pointed out potential challenges, as many of the newly qualified Medicaid-eligible patients often require a more complicated range of services than existing enrollees. In addition, emergency room volumes in some markets are booming, because the newly qualified patients do not have access to a primary care physician. While the increased volume may be positive, the rapid increase can stress an organization’s physical capacity and present staffing challenges.

Overall, the combined impact of increased revenue growth rates and greater cost controls yielded improved profitability. According to Fitch, the median operating margins for 2015 and 2014 were 3.5% and 3.0%, respectively. Operating earnings before interest, taxes, depreciation and amortization (EBITDA) margins demonstrated similar results. The increases follow similar improvements from 2013 to 2014, but all three agencies observed that the gains in productivity were more widespread this year. Fitch reported gains in all rating categories, while Moody’s and S&P observed similar results. None of the CRAs mentioned the improving economy as a major factor in revenue growth, but each agency noted that the economy will present a challenge to employment costs in the near term.

Non-Operating Income and Cash Flow

It is fortunate that operating performance improved in 2015, as poor investment returns were a drag on non-operating income. Overall EBITDA margins were good, because of the operating performance. Debt service coverage (DSC) also showed improvement, as focus on revenue cycle improvements and limited capital spending also contributed to cash flow. In addition, historically low interest rates and high demand for municipal bond debt helped keep interest expense very low for providers in nearly every rating category.

Fitch discussed the extent to which hospitals are using technology and better management practices to improve the revenue cycle, despite challenges presented by changes in payor mix. As pointed out by Fitch, “while high deductible health plans have become more prevalent, management teams have become more adept at managing the seasonality of patient volumes. The investment in and focus on billing, coding and collections continue to reduce denials, improve collections and enhance overall cash flow.”

Liquidity and Capital Spending

The ubiquitous strength in profitability and increased focus on the revenue cycle have helped maintain liquidity, despite paltry investment returns in 2015. The CRAs observed that days’ cash on hand, cash to debt, and other liquidity measures were fairly stable in 2015.

All three rating agencies observed a noticeable divergence in the level of capital spending between the largest (and typically higher rated) systems and the smaller (usually lower rated) systems. Moody’s noted that, “capital spending remained below depreciation at 0.9 times for the smallest hospitals while the largest hospitals continue to spend above depreciation at 1.3 times.” Overall, capital spending did increase slightly in 2015 after hitting an eight-year low in 2014. However, average age of plant continued to decline. All three rating agencies noted that a large (and growing) percentage of capital spending is focused on IT projects.

The construction projects that many providers are undertaking are aimed at modernizing existing facilities and building smaller structures to provide better access in furtherance of population health goals. None of the rating agencies noted a particular concern with the average age of plant, and the reduction in capital expenditures generally has a positive impact on liquidity.

Trends and Expectations

The following themes were common to all median reports:

  • A moderation of the increase in revenue is expected in 2016, as the baseline level of volume now includes the newly-qualified Medicaid recipients.
  • Each agency pointed out the challenges presented by the improving economy. Tight labor markets will likely lead to higher salary and benefit costs, and “the movement toward population health management and a growing focus on chronic disease management have increased the competition for, and cost of, nurses in certain markets,” according to Fitch.
  • Similar to last year’s reports, all three CRAs observed that risk or value based reimbursement programs have been slow to take hold, but the expectation is that these will accelerate at some point. The most efficient providers—who also tend to be the highest rated—stand to benefit most from this trend.
  • Another trend carried over from last year is continued efficiency initiatives through increasing use of technology and further consolidation/affiliation, especially where larger systems acquire weaker providers that lack the scale to keep up with the pace of change.

While the trends above tend to support increased divergence between the highest rated (typically larger) providers and lowest rated (typically smaller) providers, 2015 was a good year across the rating spectrum.

Unlike 2014, the lower rated categories enjoyed operating and EBITDA growth at a similar pace to the higher rated organizations. Also, most balance sheet measures remained flat from 2014 to 2015 in all rating categories. Improved operating margin was offset by weaker non-operating margins (mainly lower investment returns) leading to flat growth in cash balances.

S&P, Moody’s and Fitch all signaled that 2015 is likely to be as good as it gets for the hospital sector. With the full force of increased Medicaid enrollment, operating efficiencies from IT and management initiatives and greater economies of scale through consolidation and affiliation, most providers enjoyed excellent margins. Unfortunately, pressures from tighter labor markets and demands to push toward population health management will likely create strong headwinds in the latter half of 2016 and beyond. Further, the CRAs see relatively good performance of the lower rated organizations as a temporary phenomenon. It is likely that the long-term trend of greater consolidation and bifurcation of rating categories will continue in coming years.

About The Authors

Jason Dopoulos
Senior Managing Director
620 Newport Center Dr.
Suite 690
Newport Beach, CA 92660
(949) 531-4040

Jason Dopoulos

Senior Managing Director

Jason has been with the firm since 2007 and currently manages its office in Newport Beach, California.

Throughout his time at Lancaster Pollard, Jason has structured a range of bond transactions and mortgage loans for over 100 expansion, new construction and refinance projects with a total loan amount of over $3 billion. He has a thorough understanding of both conventional and federal financing structures for both taxable and tax-exempt borrowers, including FHA and USDA mortgage insurance and loan programs.

Jason served as the vice chair of the National Investment Center (NIC) Future Leaders Council in 2015 and chair in 2016. In addition, he has spoken at numerous national health care conferences. He holds a master’s degree in business from the Fisher School of Business at The Ohio State University and a master’s in health administration from The Ohio State University College of Public Health.

Ritchie Dickey

Ritchie Dickey

Ritchie Dickey, CFA, is a vice president with Lancaster Pollard in Atlanta. He specializes in hospital, senior living and housing finance structures and has completed over $617 million in closed transactions.


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